Houston, we have a problem: Iceland’s capital controls

Thorvaldur Gylfason

01 June 2011



Following the collapse of Lehman Brothers in 2008, the first country to freeze was Iceland. Within a week in early October 2008, Iceland‘s three main banks, all private, accounting for 85% of Iceland’s commercial bank assets, crashed. The remaining 15% of the banking system caved in shortly thereafter. Figuring prominently among the factors behind the crash were incompetence, corruption, and criminal misconduct as is clear from the 9-volume, 2,400-page Special Investigation Commission Report of 2010, commissioned by parliament (see Gylfason 2010). Under new, capable management, the Financial Supervisory Authority of Iceland has referred 66 cases involving more than 100 individuals suspected of breaking the law to the Special Prosecutor‘s office whose staff expanded from 3 persons 6 months after the crash to 70 persons today, soon to become 80.1

The biggest financial collapse in history?

The financial collapse of Iceland in 2008 was, by several indications, the costliest such crash on record.

  • First, the financial damage inflicted on creditors, shareholders, and depositors abroad as well as at home is estimated to equal about 7 times Iceland’s GDP, a world record.
  • Second, the fiscal cost of the crisis, including the cost of recapitalising the failed commercial banks as well as the technically bankrupt central bank, is considered by the IMF to equal 64% of GDP, breaking the previous world record held by Indonesia whose fiscal cost of the financial cleanup after the East Asian crisis of 1997-1998 amounted to 52% of GDP.
  • Third, the three “big” Icelandic banks’ collapse in 2008 would, had they been American, make the list of the 10 largest bankruptcies of all time in the US (Figure 1), a remarkable result in view of Iceland’s population of 318,000.

Figure 1. Ten largest US and Icelandic corporate bankruptcies of all time ($ billion)

Source: Financial Supervisory Authority – Iceland.

Enter capital controls

Under extreme duress after the crash, Iceland also became the first industrial country in more than 30 years to call on the IMF for help, having declined several suggestions by friendly foreign governments to seek such assistance earlier. The Fund’s rescue operation has proved to be quite successful, with generous financial support from the Nordic countries that, to make ends meet, contributed more resources to the operation than the IMF was allowed to. Of the $5 billion required to bolster the central bank’s foreign exchange reserves, the IMF provides $2 billion and the Nordics provide most of the remaining $3 billion. This is a lot of money for a country whose GDP is $13 billion. The drop in Iceland’s GDP after the crash was limited to about 10% over the course of two years or so and unemployment has stayed below 10%. Some other European countries with recent IMF-supported programmes such as Ireland and Latvia have suffered larger output losses and higher rates of joblessness.

The IMF programme

The IMF-supported Iceland programme, scheduled to be completed in the second half of 2011, has two notable features.

First, no attempt was made to secure payback to foreign creditors. This was impossible given the huge scope of the shortfall. Those who view the IMF as a collection agency for commercial banks will certainly not be able to find support for this view in Iceland. On the contrary, through bankruptcy proceedings and with tacit support from the IMF, the Icelandic banks were walked away from a variety of claims, resident and nonresident, loans and bonds, and claims by banks and nonbanks.

All three banks were put under administration, split into old banks and new banks on the basis of residence of claim. The old banks were left with their dodgy assets as well as some good ones in addition to foreign debts that the resolution committees put in place to liquidate them. The three new banks, under new names, took over deposits that were fully guaranteed and provided uninterrupted banking services at home, receiving fresh injections of capital. Two of them are now owned by their foreign creditors and the third, Landsbanki, now again the largest of the three, is under majority ownership by the Icelandic state. 

Second, in a 180 degree turn from its handling of the East Asian crisis of 1997-1998, the IMF allowed Iceland to impose strict controls on capital movements, inward as well as outward (International Monetary Fund 2010; see also Yeyati 2011). The controls were originally envisaged to be in effect for 2-3 years, meaning that they should by now have been for the most part, if not completely, dismantled. The reality has turned out differently. The Icelandic authorities have recently sought authority to keep the controls in place until 2015.

Houston, we have a problem

The main reason given for the imposition of the capital controls in late 2008 was the carry trade (Benediktsdottir et al. 2011). The idea was that, without strict controls, the holders of “glacier bonds” equivalent to about 50% of GDP would rush to unload their holdings, thereby making the Icelandic króna plunge even further, as if the 50% depreciation from peak to trough surrounding the financial crash was not enough.

The balance-sheet effects of significant further depreciation of the króna on households and firms were considered unacceptable. The “glacier bonds”, mostly local currency deposits held in Iceland by foreigners, who, apparently impervious to the enormous exchange rate risk involved as well as to Iceland’s long history of high inflation and economic mismanagement, had borrowed at very low interest in yen or Swiss francs and bought Icelandic króna to be deposited in high-interest accounts plus government bonds in Iceland. These deposits are for the most part still locked up in Iceland. From the authorities’ point of view, the initial justification for controls still remains intact.

Capital controls have a tendency to overstay their welcome. Deprived by law of the possibility to take their funds abroad, foreign carry-traders and local investors – pension funds, for example – are grounded at home where they find it best to buy government bonds, thereby facilitating the government’s financing of its budget deficit and thus also reducing the pressure on the government to rein in the deficit. Another hidden benefit of extended controls from the authorities’ point of view is the increased demand for real estate from local investors with nowhere else to go because their entry into the local housing market helps reverse the drop in real estate prices during and after the crash. Through these channels, and others, capital controls tend to become self-preserving.

This is not all. The extent to which Icelandic exporters fail to bring home their foreign exchange earnings because of their limited confidence in the króna is not well known, or at least not publicly acknowledged. To the extent that exporters do not bring home all their foreign earnings, they help keep the currency weak. The exchange rate of the króna in terms of euros is still about the same as it was immediately after the crash in October 2008. The 50% nominal depreciation of the króna vis-à-vis the euro since before the crash shows as yet no signs of partial reversal as occurred, for example, in Indonesia and Thailand after the East Asia crisis in 1997-1998. Indonesia and Thailand, famously, unlike Malaysia, did not impose capital controls. The IMF would not let them. Clearly, however, the depreciation of the króna has greatly reduced imports and bolstered the value of exports, lifting them from the equivalent of one-third of GDP since long before the crash to 56% in 2010. This is a good sign.

The Rolex index

The economic history of Iceland, and of the world, is replete with stories of intrusive controls and ingenious, and sometimes unlawful, attempts at circumvention of such controls. It is important to remember that the liberalisation of trade after the Second World War and of investment and other capital flows after 1980 grew out of a long experience of the corrosive and ultimately counterproductive influence of unwarranted exchange and trade restrictions.

Like other forms of prohibitive taxes, excessive controls not only distort economic incentives but they can also be deeply demoralising and damaging, especially when they are permitted to outlast their immediate usefulness. The Rolex index – the number of high-end watches sold per person – is high in Iceland not necessarily because the economy’s top echelon is doing so well but rather because ordinary people have no access to foreign exchange beyond their monthly allotment of €2,150 for foreign travel plus their modest credit card limits, so they are rumoured to buy expensive watches at home for resale at a discount abroad. Welcome back to the 1950s. Iceland and the IMF need to find as quickly as possible a way to implement their strategy to restore, as intended, free capital mobility and full convertibility.


Benediktsdottir, Sigridur, Jon Danielsson, and Gylfi Zoega (2011), “Lessons from a collapse of a financial system”, Economic Policy, 26(66):183-235.

Gylfason, Thorvaldur (2010), “Iceland’s special investigation: The plot thickens”, VoxEU.org, 30 April.

International Monetary Fund (2010), “Capital inflows: The role of controls”, IMF Staff Position Note SPN/10/04, 19 February.

Special Investigation Commission (SIC) (2010), “Report of the Special Investigation Commission (SIC)”, report delivered to Althingi, the Icelandic Parliament, on 12 April.

Yeyati, Eduardo Levy (2011), “Are capital controls effective?”, VoxEU.org, 20 January.

1 The permanent secretary of finance at the time of the crash was recently handed an unconditional two-year prison sentence for insider trading in Landsbanki stocks; he appealed the verdict to the Supreme Court.



Topics:  Europe's nations and regions Global crisis International finance

Tags:  Iceland, global crisis, capital controls

Thorvaldur Gylfason

Professor of Economics, University of Iceland; Research Fellow, CESifo and CEPR Research Fellow